Moving forward with the LIBOR Transition

David Bull, director of data management and strategy at Refinitiv, analyses what needs to be addressed during the LIBOR transition, including identifying a suitable replacement, LIBOR legacy issues, and why the financial services industry needs to act sooner rather than later.

At this point, not even a pandemic can derail the long-anticipated retirement of LIBOR (the London Interbank Offered Rate) at the end of 2021.

That means time is running out for market participants holding trillions of dollars’ worth of LIBOR-based contracts to transition their portfolios to one of the new risk-free rates (RFRs).

Despite the recent announcement by IBA to extend the cessation deadline for certain USD LIBOR terms, the deadline will require the full attention of all organisations — along with the right data and tools to make this switch with as little market disruption as possible.

Finding a replacement

While no single alternative has been identified that can provide the global reach of the LIBOR, public and private working groups have been quick to create or identify alternative reference rates across major currencies.

These include:

  • Secured Overnight Financing Rate (SOFR) for US dollar
  • Sterling Overnight Index Average (SONIA) for British pound sterling
  • Euro Short-Term Rate (€STR) for euro
  • Swiss Average Rate Overnight (SARON) for Swiss franc
  • Tokyo Overnight Average Rate (TONAR) for Japanese yen 

However, none of these RFRs were originally designed to be LIBOR’s direct equivalent, and all are based on overnight rates. LIBOR is typically quoted at forward-looking points, which makes it easier to adjust to fluctuations in global interest rates.

Regulators and benchmarks administrators are looking to address some of these issues by creating forward-looking term rates that could be used as an alternative in certain workflows. 

Addressing legacy issues

A key hurdle in making this transition is in legacy LIBOR contracts that provide no ability to revise fallback language. While some asset types, such as derivatives, can be addressed by fallback rates and protocols being introduced by legislative bodies and working groups, others, such as bonds for example, will automatically fall back to terms outlined in bond prospectus documentation. And that prospectus was written in a world where a long-term unavailable LIBOR was not foreseen.

One proposed June change from the UK’s Financial Conduct Authority (FCA) would enable the continued publication of a LIBOR number “using a different and more robust methodology and inputs.” However, as trillions of dollars’ worth of contracts move away from LIBOR, contract modifications and hedging arrangements may be expensive and extremely burdensome.

The LIBOR transition: Why you need to act now

The ability to revalue existing assets based on new RFRs is critical. Because LIBOR is so deeply embedded across a myriad of processes throughout the financial services industry, organisations will need a multitude of data points and tools to support a transition to alternative reference rates and benchmarks.

With time running out, market participants need to act now to have the appropriate plans in place to manage this transition efficiently and to meet the industry deadlines.

Consider taking these four steps to prepare your institution — and your customers — for these changes.

  1. Understand your risk and identify your exposures

A good starting point is to develop an understanding of the organisation’s exposure to LIBOR. Where is LIBOR currently being used, or which reference rates are currently being used? Which processes and functions are LIBORs feeding into? What fallback conventions are applicable?

Once the touchpoints have been identified, alternative benchmarks and reference rates need to be assessed. Scenario analysis tools can help firms measure the impact of interest rate swaps and floating-rate notes on LIBOR-based contracts in your existing portfolios.

A calculator for compounded rates for major RFRs can help firms keep up as more market-standard methodologies continue to be developed.

  1. Start reducing reliance on LIBOR now

Begin trimming your legacy exposure wherever possible and start talking to your clients now about the changes going on in the market and any new products that are being developed.

Then start integrating RFR-based tools into your pricing models and calculators so that you can begin transitioning current transactions that go beyond 2021 to alternative rate structures.

  1. Engage with your employees, advisors and regulators

A smooth transition away from LIBOR will require effective leadership from the top down. Establish LIBOR migration programs across front, middle and back offices, and identify senior executives who will be accountable for managing the transitions.

Despite the looming deadlines, many core issues surrounding the global move away from LIBOR remain fluid. That means organisations need to stay on top of the news, along with communications from regulators and industry groups, so that they can make informed decisions about their own transitions.

  1. Find the right data — and the right data partner — to help you make a more seamless transition

Data is — and will remain — at the heart of navigating these changes. Newly available data and new RFRs will drive new curves, pricing and content sets. But data is just the beginning.

As the move away from LIBOR gathers momentum, being able to access robust, trusted data, along with relevant insights and tools, from a single source will become an invaluable necessity for a smooth and effective transition.

Click here for a collection of resources that we hope can help you manage better and deal with the complexities that will arise and facilitate the start of your organisation’s smooth transition.